Arnold Kling  

The Government Mortgage Subsidy

David Kennedy talks to Russ Ro... Boaz on Media Bias...

ABC News quotes PIMCO's Bill Gross.

"Without government guarantees, mortgage rates would be hundreds -- hundreds of basis points higher, resulting in a moribund housing market for years."

Is he just talking his book, or is he serious?

The standard estimate in the literature is that Fannie and Freddie reduce mortgage rates by 25 basis points or less.

What Gross is saying might be true if you are an unqualified borrower buying a house with little or no money down. But once upon a time we had a mortgage market in which borrowers with documented income and assets took out loans for 90 percent or less of the price of the house they were buying. If we went back to those types of mortgages, a typical borrower would not save hundreds of basis points by having Uncle Sam as a co-signer. If the guarantee is worth that much, then there is something fishy about the loans that are being guaranteed.

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COMMENTS (15 to date)
Two Things writes:

Maybe he means just right now, mid-2010. Perhaps if it weren't for government interventions mortgage loans would be very costly because of the risk that the collateral will lose value rapidly (i.e., return to long-term trend), and because of inflation fears (due to profligate government money-printing).

If government stopped subsidizing mortgages, the unsubsidized rate might not be "affordable" (to buyers) until home prices fell a lot. In the short run few houses would be sold as sellers and buyers tried to wait out the adjustment.

Hyena writes:

He's talking about right now. Currently the SOEs are the only thing really moving mortgage securities. Without the government making this market, it would evaporate and lenders would have to assume greater risk, causing rates to skyrocket.

The market is better capitalized than any individual lender, losing the only facility currently working in that market would be a disaster.

Well, a "disaster". I wouldn't really mind.

pj writes:

The housing market would only remain moribund until housing prices fell. There would be plenty of activity at lower price levels.

Gross is indeed talking his book. Risk markets would fall apart without government support. They will fall apart even with government support, but later and more dangerously.

wlu2009 writes:

"The housing market would only remain moribund until housing prices fell. There would be plenty of activity at lower price levels."

I think this is exactly the government and Gross's fear. The price levels needed to revive the market without GSE support would result in another precipitous decline in housing prices resulting in massive wealth erosion and a double dip. In that way, keeping the GSE's around is stimulus the government pays for by taking on risk, rather than printing money (although they do continue to pump billions into the GSE's to keep them alive). It may rather be better to slowly wean the mortgage market off the GSE's and let the economy and consumers adjust to the price change over time.

I'm as in favor of eliminating mortgage interest deduction and government loan guarantees as the next guy, but pulling the rug out from underneath a barely growing economy may be more painful than is worthwhile. Not to mention there is no political appetite on either side to move forward with either of those initiatives.

Various writes:

Well I think Gross may be exagerating a tad, but I think the concept is correct. I personally would estimate the difference at about 150 bps. There are 3 reasons for this spread, and you've identified 2 of them. The reasons are:

1. a pure pricing subsidy. In otherwords, the agency loans have lower interest rates than similar non agency loans. I think this difference is about 75 bps. I don't see where you get your estimate of about 25 bps. Compare the agency rates for jumbo non-conforming for example, and I believe the spread is larger than 40 bps.

2. An adverse selection issue. I'm not sure how big this effect is, but the agencies are underwriting product that wouldn't otherwise be underwritten. Not a lot of product mind you, but some. The agency guidelines are very rigid, and in a minority of cases, they underwrite loan product that a thinking human loan officer excercising good judgment would not underwrite.

3. Subsidizing collateral prices. I think most lenders are of the opinion that, if the agencies weren't in the market, the value of the collateral (i.e., homes) would be more volatile and perhaps falling significantly. In this case, the subsidy is not between the agency loan prices and non-agency loan prices, but between agency loan prices and non-agency loan prices in the absense of agencies participating in the market. I'm not sure you've identified this last factor.

If you don't believe the importance of this last factor, look at the spread between agency financing for, say apartments, and bank financing for commercial properties other than apartments. (agencies only underwrite apartments in the commercial sector). I would estimate this spread at about 250 bps.

Jeremy, Alabama writes:

"If the guarantee is worth that much, then there is something fishy about the loans that are being guaranteed."

A great quote, and unanswerable. Thanks.

ChrisW writes:

Most of the comments have it right. And the standard estimate that you're quoting, Arnold, is an estimate for normal market conditions over the past few years and the pre-bubble era.

A dude writes:

100s of basis points is definitely accurate. Implicit in the statement is that this subsidy is needed right now because without it house price would indeed fall, and with them the whole debt-based economy -- we are 10% house price away from the critical mass of underwater mortgages that would result in a collapse.

There would not be more activity at lower prices, because those who think they are cash buyers now would lose their jobs and switch into self-preservation mode.

Bill Gross labeling it a cul-de-sac is a classic (and an understatement)

Manny C writes:

Gross always talks his book

Elvin writes:

I'd put the subsidy at 50 to 75 basis points, but on shorter term loans. As Arnold has argued in the past, mortgages would probably be 5 or 10 year balloons--the borrower would be taking more interest rate risk. Given how battered the housing market already is, I don't think it would actually have that much effect. Ever lower rates hasn't sparked the market, so the interest rate effect is not very big right now (and may never have been all that big).

James A. Donald writes:

Hundreds of basis points sounds low to me - indeed I would say tens of thousands of basis points, because I am seeing a lot of very fishy sales.

What I suspect is happening is that most sales consist of someone unloading a house at substantially above the market price to some wino who has no idea what he is signing other than that the guy asking him to sign has given him a large bottle of whiskey and promised him another.

At alarmingly frequent intervals the FHA announces tighter lending standards, but the new improved lending standards always have loopholes in them big enough to sneak in their racial quota of no hablo English Mexicans, and all sorts of strange people pour in through the same loophole.

Despite numerous supposed FHA rises in standards, I am still seeing ads about how easy it is to qualify for an FHA loan, and how you don't have to explain where the money came from for your deposit (wink wink, nudge nudge), not withstanding the fact that every so often the FHA introduces a new set of rules saying you do have to explain where the deposit money came from, and then a newer set of rules saying your really, really do have to explain where the deposit money came from, and this time they really mean it.

James A. Donald writes:

Various writes:

The agency guidelines are very rigid, and in a minority of cases, they underwrite loan product that a thinking human loan officer excercising good judgment would not underwrite.

Pull the other one. It has bells on it. Most FHA loans stink mightily. Easy credit to winos and wetbacks was government policy and still is government policy. The financial crisis was that private enterprise was unable to go along with this government policy any longer. The FHA has been announcing ever higher and more rigid standards at ever more frequent intervals, but they do not in fact follow these standards.

Tracy W writes:

wlu2009 - if now's not a good time, when will it be? When the baby boomers really start retiring?

Furthermore, there's status quo bias in politics, if subsidies are withdrawn slowly, then each decision to withdraw a bit more can be fought over, and the withdrawal thus could be reversed. If subsidies are withdrawn rapidly, then you have only one political fight. Consequently, slow withdrawal of subsidies creates greater political risks than a rapid withdrawal, and thus people are less likely to invest on the basis of a reduction in subsidies, and perhaps less likely to invest at all, so increasing the economic pain. I think the approach of "cut it now" has a lot going for it.

mattmc writes:

Can't we just look at the jumbo / standard differential to get a real measure of this?

Shawn Smith writes:

The average 30 year fixed standard mortgage rate is around 4.5%. For jumbo mortgages, it is around 5.25%, or 75 basis points higher. If the government subsidies were to be eliminated, it would affect the lower end of the housing market negatively. But, I would expect the higher end of the housing market to be affected positively since the government would be taking less risk and less debt thereby reducing treasury interest rates even further. So, Fannie/Freddie/FHA may be propping up a part of the housing market, but it's a part of the housing market that should not be propped up (low-income households that should be renting instead of owning).

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